The ECB’s Shifting Regimes

The European Central Bank (ECB) is likely to commence a broad-based asset purchase programme, i.e., quantitative easing (QE), in the first quarter of 2015. As it stands, the eurozone is stuck in a liquidity trap, the risk of deflation is rising and inflation expectations are deviating from their long-term anchor. With the private sector deleveraging and the policy rate near zero, additional easing will require expanded asset purchases.

The impact of asset purchases on the economy will mainly work via the exchange rate channel by depreciating the euro. We believe that it will also work via the expectations channel by convincing households and companies that the ECB is committed to its inflation target, thereby influencing their intertemporal consumption and investment decisions.

But the boost to growth from ECB asset purchases will abate unless eurozone governments contribute, too. Monetary policy alone is insufficient to pull the eurozone out of the liquidity trap: Yields on credit “risk-free” assets are already below levels achieved by other central banks that conducted similar policies. Fiscal, structural and monetary policies need to work in unison. Financial markets are likely to endorse larger fiscal deficits if they are underwriting growth-enhancing reforms and productivity-enhancing investment.

The ECB's existing liquidity-providing measures – targeted longer-term refinancing operations (TLTRO) and asset-backed securities and covered bond purchase programmes – will not materially boost the size of its balance sheet. We expect these policies to increase the balance sheet from €2 trillion today to €2.3 trillion–€2.6 trillion by the end of 2015, after netting off other assets maturing in the course of next year.

An asset purchase programme of €500 billion, in addition to existing policies, would increase the ECB's balance sheet back to its early 2012 level of €3 trillion, with government bonds to form the largest component of this programme owing to their liquidity. However, purchases of investment grade corporate bonds, agency bonds, blue chip stocks and gold should also be considered as they would ameliorate legitimate moral hazard concerns.

In shifting to a broad-based asset purchase regime, the ECB should amend the configuration of interest rates on its standing facilities. The rationale for applying a negative interest rate to excess reserves in the presence of asset purchases is contentious: It is equivalent to a compulsory tax on banks, while having a diminishing portfolio reallocation impulse.

What does it mean for Europe’s banks?In the current regime, banks have the option, but not the obligation, to hold excess reserves. Eurozone banks currently hold excess reserves of about €100 billion. Yet banks in possession of them are unwilling to lend them to banks short of reserves; those banks, therefore, need to borrow them from the ECB. The negative interest rate is meant to incentivise banks to lend to each other. Measured by unsecured overnight lending volumes, however, inter-bank lending has not materially increased since the ECB began charging banks for holding excess reserves.

One key argument that would address the need to increase inter-bank lending, therefore, is to cut interest rates even further. However, by shifting to a broad-based asset purchase regime, the ECB would flood the banking system with reserves. And banks would have no choice but to hold them. An additional €500 billion in QE, coupled with existing liquidity-providing programmes, would raise excess reserves to about €1 trillion, ceteris paribus. Banks would have to hold those reserves regardless of how often they are recirculated, as excess reserves can only be eliminated by trading with the ECB.

There is no point in taxing banks with negative interest rates for having to hold excess reserves they cannot avoid. But raising the interest rate applied to excess reserves from negative 0.2% at present poses a dilemma: The ECB might send a confusing signal if it buys assets with one hand and hikes rates with the other. There is a simple solution, however.

By raising the ECB’s deposit facility interest rate back to zero and its Main Refinancing Operation (MRO) rate to 0.15% and by eliminating the 0.1% spread applied to TLTRO auctions, the ECB would ease financing conditions for banks. Banks would benefit by no longer being charged for holding excess reserves, while the cost of borrowing funds via the TLTRO will be unchanged at 0.15% (under the current regime, TLTRO loan costs equal the 0.05% MRO rate plus a fixed 0.1% spread).

We believe that banks would likely reduce borrowing money for one week at the MRO auctions because they would obtain enough reserves from selling assets to the ECB, so the higher MRO will not matter. Short-term interest rates would rise a little since 0% will likely become the new money market floor; but this signal would be overwhelmed by the larger quantity of euros in circulation.

Cheap money alone is not sufficientThe ECB is right to be concerned about the moral hazard issue vis-à-vis the fiscal agents when it buys government bonds. The more it does, the lower the incentive will be for governments to perform their part. But if governments are unwilling ‒ or unable ‒ to reform, that is their area of responsibility, not the ECB’s.

With increasing numbers of fringe political parties wanting to exit the euro, the eurozone’s governments should begin a debate about the long-term governance structure for fiscal policy. The euro is built on the assumption that fiscal policy can be decentralised. But decentralisation is not working. There is no historical evidence to support this assumption in the context of a large, multi-country monetary union. The eurozone will likely last longer with an accommodative monetary policy, but it will only endure with structural reforms and centralised fiscal capacity.

For long-term investors, this means they may want to continue to focus on assets that benefit from an accommodative ECB, but keep an eye on the fiscal agents, too. Without their contributions, Europe’s sovereign debt crisis is far from over.

The COVID-19 crisis is likely to accelerate many underlying, secular disruptive forces already affecting economies and financial markets. This may only increase the difference between those companies, sectors, and countries that are being disrupted, and those that are acting more like disruptors. Distinguishing between the two is becoming crucial.

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